Conditions are building for a real-estate revival – for the right properties


Peaking interest rates and prices near cyclical lows will reenergize real estate as an alternative asset class in 2024, but there are key variables at play, writes Zsolt Kohalmi

In recent times, yields on real-estate investments – cap rates – have been in a category five storm, with an unforeseen interest-rate environment wreaking havoc across the property world. As many people view real estate as a proxy for fixed income, when interest rates go high and money market funds or bonds become a genuine alternative, real estate suffers. But the key point now is that, almost universally, analysts believe we’re near the top of the rate cycle.

What we don’t know is how fast rates will go down. There’s a big caveat, too: there could be a rebound in inflation expectations, either because energy prices go up due to challenges in the Red Sea, or because Donald Trump gets elected again and injects a lot of money into the US economy. So the descent may be delayed. Still, rates will likely start to be reduced – although probably not to the lows we have seen since the 2008 financial crisis. But psychologically, cuts even in increments of .25 percentage points, will create expectations of further cuts and with those, momentum.

As an investor, if you see that we’ve arrived at the top of the hill and are heading down – and you see that we’re very near cyclical lows in real-estate pricing, versus all-time highs in almost every other asset class – then the logical thought process is that it’s a good time to commit to real estate.

Then you have the rental side of the equation, and that is hugely varied depending on sector and geography. If you’re in the US and in offices, you’re in big trouble, because the pandemic has significantly accelerated underlying trends around working patterns. Lower demand for space coupled with an office glut following years of cheap development have led to rents compressing because of the high vacancy rate. The rise of AI is going to disrupt working practices even further.

Meanwhile, for the first time in a long time, even US multifamily homes are somewhat oversupplied, so you’re seeing declining rents there, too. It’s a completely different picture in Europe, where lengthy planning processes mean we are undersupplied in almost every real-estate asset class. This is even true in offices, where the European vacancy rate is well under half that of the US. In Europe, rents have been driven up by the lack of supply and high demand – expensive mortgages mean more renters. This is especially true in desirable asset classes such as the London residential sector.

If you take the two values – cap rates heading for improvement and strong rents in the right sector and location – there’s an argument for really interesting growth in real estate over the next 12 to 36 months. But you have to buy today to benefit, and really pay attention to that divergence in fortunes.

Another major shift is being driven by ESG, which is rendering a lot of buildings obsolete. The result is a bifurcation between modern properties, that are objects of desire, and older, less efficient ones, that are not. For most companies, real estate generates close to 50 percent of their carbon emissions. When they want to make good on their promises to stakeholders to lower emissions they need to seek ever greener buildings. Individuals also see the appeal of more efficient buildings, especially given recent energy price shocks. That will mean obsolescence and pain for very old properties which are not easy or efficient to upgrade.

There is a geographical difference here, too, partly due to the way we think about ESG. In Europe, we’re focused on the E – environmental – whereas the United States is focused on the S – social. The first hit from ESG will come in Europe, because in the past few years European countries have been passing legislation on the energy efficiency of buildings. So we have a carrot and a stick – rent premiums for greener buildings, while at some point you simply won’t be able to rent properties that don’t meet certain criteria. This is a trend that will be exported to the US in time.

This transition will bring numerous challenges. There’s still an acute post-pandemic skills shortage in construction; it’s even bigger when it comes to people trained to install heat pumps, for example. Then there’s the issue of rent controls in the residential sector in some countries. Making buildings green costs money and that needs to be covered by an increase in rent. But that won’t necessarily push up the occupier’s total cost much because higher rent is balanced out by lower energy bills or service charges. However, where there are very rigid controls on rents, it’s not possible to recoup the greening investment.

Despite these challenges, however, the direction of travel is clear. That will start to show in capital values – if you have something very green, people will pay you a big premium for it. And if you have something problematic, you may not find any takers.

The big picture is that this is a good time to invest in real estate, because the rate cycle that’s been one of the key drivers of the sector’s problems should now be one of the key drivers of the uptick. The challenges for existing owners who may be over-leveraged are becoming opportunities for buyers, and values at near cyclical lows are likely to improve over the course of 2024. But if you are going to invest, you had better get your sectors, locations and ESG points right, because they will have a much stronger influence on performance than they would have had in the past. The divergence in all those three variables will only increase.

Zsolt Kohalmi is global head of real estate and co-CEO at Pictet Alternative Advisors, a leading European specialist in alternative asset management

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